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According to a recent survey [1], the amount of total funds raised by startups incorporated in Japan reached a record high and exceeded JPY 800 billion in 2021 (the total funding amount was just shy of JPY 90 billion in 2013). Despite the weakening economy and stock market, the pace does not seem to have slowed down in the first half of 2022 during which startups have been reported, in the same survey, to have raised more than JPY 400 billion. Although higher growth rates can be observed in some other regions of the world, the startup industry in Japan has continued to grow steadily during this decade.
This growth has been aided by the Government’s strong intention to support and further accelerate the growth of the startup industry in Japan. The Japanese Government’s “Basic Policy on Economic and Fiscal Management and Reform”, resolved and released by the Cabinet in June 2022 under the leadership of Prime Minister Kishida, who took the office in October 2021, mentions investment in startups as one of five focus areas with the aim of increasing the total amount of startup fundraising to ten times its current size within the next five years. Further details should become available in the five-year startup growth plan which the Government has promised to publish by the end of 2022.
In addition to the Japanese Government’s efforts, the Japan Fair Trade Commission has been active in the area and has recently issued a number of reports and guidance in its efforts to create level playing field for startups in their transactions with large corporations or investors.
Among the growing number of startup investments in Japan, we are seeing an increasing number foreign investors. In the hope that this trend will continue and that the Government’s policies will succeed in attracting more investments in Japanese startups from overseas, this article provides a brief overview of the Japanese market standards and legal requirements for startup investment in Japan.
Trends and Market Standards for Startup Investment Terms in Japan
Overview
Unlike the NVCA Model Legal Documents in the United States or the Venture Capital Invement Model Agreements in Singapore, Japan does not have any publicly available, widely-used model startup financing documents. Startup financing documents are not standardized in Japan as in the United States and are written in Japanese in the vast majority of cases.
However, most startup investments have a similar equity structure, which is quite similar to the United States. A company issues common shares to the founders and possibly the first employees. Seed financing can be done through various ways (i.e., common shares, preferred shares or convertible debt or equity), but, once the company reaches Series A, the financing is usually raised through preferred shares until the company’s exit (convertible debt or equity is sometimes used as bridge). Employee stock options are also widely used, but stock options terms in Japan are generally less favorable to employees. For example, they are often structured as non-exercisable prior to an initial public offering and sometimes subject to vesting starting from the initial public offering. On average, the size of the stock option pool is smaller compared to that in the United States.
Liquidation Preference and Other Terms
Generally speaking, the terms of preferred shares in Japan are more favorable to investors compared with preferred shares in the United States. Having said that, the terms of preferred shares have been changing to be more founder/company friendly in recent years. With respect to the liquidation preference, it is not rare to see more than a 1x (e.g., 1.5x, 2x) liquidation preference and participation rights are still common. In other words, one should not necessarily interpret a 1.5x participation as a sign that the relevant company’s previous series of financings were weak.
Whilst the terms of preferred shares usually include voting rights, mandatory and voluntary conversion and anti-dilution protection (mostly weighted-average), it is very rare to find a cash redemption right included.
In addition to a share purchase agreement, companies and shareholders usually enter into a shareholders agreement which stipulates director appointment rights, observer appointment rights, information rights, protective provisions, preemptive rights, co-sale rights, rights of first refusal and drag-along rights. In the shareholders agreement, the shareholders also agree on the distribution of proceeds from deemed liquidation events, which will be made in accordance with the terms of the liquidation preference.
Share purchase agreements usually include indemnification provisions as well as certain call options for purchasers that can be exercised upon, among other things, a breach of the representations or warranties or covenants by the company or founder(s). This may look overly burdensome for the company or founders and it has been actively discussed whether the industry should abandon such practice (as mentioned above, the Japan Fair Trade Commision plays an important role in such discussions), but is still very common in Japan, particularly for early stage startups. Startups try, and sometime succeed in, negotiating the removal of such call option in later stages.
Foreign Exchange and Foreign Trade Act [2]
The Foreign Exchange and Foreign Trade Act (the “FEFTA”) requires foreign investors to make a filing prior to making an investment in Japanese companies that operate in a designated business sector which includes, among others, software, data processing services and internet-use support sectors. With respect to acquisitions of shares in unlisted compnies, there is no applicable monetary or volume threshold such that filing is required for an acquisition of even a single share. In the ordinary course, it takes up to thirty days (typicaly shortened to somewhere between four business days and two weeks) after the filing has been submitted for the clearance in general. Clearance can take longer if there are any national security concerns.
Summary
Startup investment in Japan may appear confusing to international investors. However, putting any language issues aside, startup investment in Japan has largely developed based on the standard practices in the United States and should be familiar to investors accustomed to investing in the United States or other major jurisdictions.
View original article here.
September 29 2022
Akihiro Tokura, Partner
+81-3-6889-7273 akihiro_tokura@noandt.com
Akihiro Tokura is a partner at Nagashima Ohno & Tsunematsu. His practice focuses on mergers and acquisitions and venture capital investments. He was seconded to law firms in United States (Silicon Valley), Israel and Brazil and utilizes that experience to advise global and local clients in cross-border investments.
[1] Uzabase, Inc. “2022 1st Half Japan Startup Finance”
[2] For further details and recent updates on the FEFTA, please see Vol. 23 and 29 of NO&T Japan Legal Update.
https://www.noandt.com/en/publications/publication20330/
https://www.noandt.com/en/publications/publication20210930-2/